Crypto’s Great Reset: How Digital Asset Investors Will Recover From The Market’s $1 Trillion Meltdown

Crypto’s history has been defined by five resets. The first came in 2014 when what was basically the only bitcoin exchange in the world, Mt. Gox, imploded following a nearly half-billion-dollar hack. The second, in 2016, was The DAO Hack, when an attacker tricked a smart contract into giving away $60 million worth of ethereum, worth $8 billion today. The third, in January 2018, occurred when the ICO bubble popped, starting a year-long decline, wiping out 60% of the crypto market or more than $700 million mostly in the form of worthless junk tokens. The fourth took place in March 2020 when crypto lost 40% of its value along with most other global financial markets.

Each reset not only led to price-market capitalization increases, they also cleared the way for rapid innovation. The two biggest exchanges in the U.S., Coinbase and Kraken, were developed out of the ashes of Mt. Gox’s implosion because their CEOs knew that people needed trustworthy places to buy bitcoin. The DAO’s implosion and the ICO crash set the groundwork for the growth of DeFi and the popularity of DAOs today, and it’s hard to imagine companies like Tesla buying bitcoin before Covid.

The fifth reset started last week. It may shape up to be the most important yet. This time the trillion-dollar market collapse was caused by a steep selloff in risky assets and the sudden evaporation of a $40 billion digital token called LUNA that backed the $16 billion stablecoin TerraUSD (UST). In contrast to the free-floating Luna tokens, each UST was designed to be worth a single U.S. dollar. A perfect storm of greed and immature technology led to the stablecoin losing its peg, and between May 7 and May 12, about $56 billion went poof.

Severe bear market crashes in the nascent market for cryptocurrencies have become almost commonplace. Consider that in the last century the U.S. stock market has only experienced five bear markets in which stocks declined more than 30%. Bitcoin is only 12 years old and the cryptocurrency market has had as many severe crashes.

At its most basic level, the most recent crypto collapse is another reminder of how get-rich-quick schemes can overwhelm common sense. The loss of so much capital is forcing the industry to reckon with the entire concept of leverage in cryptocurrency markets, forcing it to be honest with itself as to whether innovation is just dressed-up leverage and could be the death knell for an entire category of asset, called algorithmic stablecoins.
“Leverage can never make a bad investment good, but it can, and often does, make a good investment bad,” says Mark Yusko, founder of Morgan Creek, an institutional and family investment advisory firm. “And so that’s what we're seeing in the past couple of months, particularly in the past week, just an unwinding of ridiculous levels of leverage. And in the case of the Terra problem from this past week—the Luna problem—it’s just a bad idea, bad structure. You can’t collateralize an asset, that’s supposed to be stable, with an unstable asset.”

The South Korea-based Terra Foundation sought to solve this by using an algorithm to replace many of the techniques that give the U.S. dollar its stability. When price goes down, it creates an arbitrage opportunity to trade a UST token worth less than a dollar for $1 worth of Luna. Theoretically. The Luna blockchain also hosted a DeFi lending protocol, called Anchor, which paid depositors 20% yields.

For context, the Great Recession of 2008 was triggered by a housing bubble in which subprime loans were packaged and sold as new securities with pristine ratings. Their collapse triggered a loss of confidence in the market and a domino effect on financial institutions with potential exposure losses. Similarly, stablecoin TerraUSD was thought to be foolproof—until its collapse. Losses were amplified because it was backed by software few understood but piled into because it promised quick riches, says Caitlin Long, a former Morgan Stanley managing director, now building Custodia, a Wyoming-based crypto bank designed from the ground up to make money without leverage. “So much of what was cloaked as innovation was in fact leverage dressed up as something else,” she says.

One of Terra’s most high-profile investors is Lightspeed, the Menlo Park-based venture firm with $10 billion in assets under management, according to Pitchbook. They’re also one of the earliest VCs to back crypto, investing in Ripple in 2013 and recently expanding their total crypto portfolio to $600 million. A spokesperson for the company struck a defiant tone about the fallout surrounding what will likely go down as one of their most notorious investments. “We see this as a computing paradigm shift that is bigger than the ebb and flow of the short-term price of Bitcoin,” the spokesperson said. “We are doubling down, specifically in infrastructure, DeFi and emerging use cases.”